Example – What is Short Selling ?

Short selling is the selling of a stock that the seller doesn’t own in order to buy it back once it has fallen in price, netting a profit in the process.

Basically a hedge fund or large investment bank takes the view that shares in a particular company are set for a fall. The investor then borrows the shares from someone who does own them – most often a large pension fund or insurance company – and sells them in the market. Once the shares have fallen in value, the investor buys them back at the lower price and returns them to the lender.

Example

Assume shares in “Company A” currently sell for $10 per share.

Short seller just borrows (he did not paid any money to the owner of the share) 1000 shares of “Company A” and sells for $10,000 hoping that that price will go down.

Now , short seller has net cash of $ 10,000 in his trading account and he has to owe 1000 share of “Company A” to the actual owner, which he borrowed.

As per short seller’s hope price went down, say $8 per share. He buys 1000 shares back from market for a price of $8 (Paid only $8,000 )

Below is just a little information on short selling from my small unique book “The small stock trader”:

Short selling is an advanced stock trading tool with unique risks and rewards. It is primarily a short-term trading strategy of a technical nature, mostly done by small stock traders, market makers, and hedge funds. Most small stock traders mainly use short selling as a short-term speculation tool when they feel the stock price is a bit overvalued. Most long-term short positions are taken by fundamental-oriented long/short equity hedge funds that have identified some major weaknesses in the company. There a few things you should consider before shorting stocks:

• First of all, you want to short stocks when the market sentiment is negative (in the bull market most stocks go up, and in the bear market most stocks go down);
• You should also look for changes, besides an expected profit taking, that may trigger a stock price decline, such as massive insider selling, a lower-than-expected earnings report, profit warning,a dividend cut, etc.
• Beware of short squeezes and takeover bids (small caps are more vurnerable);
• Check the short interest (ratio) and its trend;
• Be quick (stock prices decline several times faster than they rise);
• Cut the losses short and don’t average down your losing short positions to avoid being caught up in a cross fire of a Volkswagen short-squuezelike scenario;
• For longer tern short positions, one of the best candidates to short are the former leaders, big winners, close to the top of the bull market, as these same winners of the last bull market usually fall the hardest in the next bear market. Early–cyclical stocks are also good candidates to short in the beginning of bull/bear markets.

Despite all the mystique and blame surrounding short selling, especially during bear markets, I personally think regular short selling, not naked short selling, has a more positive impact on the stock market, as:

• Short selling leads to better price discovery;
• Short selling increases liquidity, which in turnnarrows the bid/ask spreads;
• Short selling may also serve as a hedging tool or a pairs trading tool;
• Short selling provides profit opportunities in bear markets;
• Short sellers are a counterforce against upside-biased insiders, stock analysts, investment bankers, stockbrokers, stock investors, and creditors.

Lastly, small stock traders should not expect to make significant profits by short selling, as even most of the great stock traders (Jesse Livermore, Bernard Baruch, Gerald Loeb, Nicolas Darvas, William O’Neil, and Steven Cohen,) have hardly made significant money from their shorts. it is safe to say that odds are stacked against short sellers. Over the last century or so, Western large caps have returned an annual average of between 8 and 10 percent while the returns of small caps have been slightly higher.
I hope the above little information from my small unique book was a little helpful!